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Dealmaking in The Web 2.0 Era

December 2005

Dealmaking in The Web 2.0 Era: A focus on advertising drives Internet mergers and acquisitions

Brent Shearer December 1st, 2005

In what some are hailing as the second coming of Internet consolidation, Time Warner Inc.'s American Online Inc. division has been transformed from a player in one of the most troubled mergers in history to an attractive target or a partner for many of the New Economy's major operatives. It's been a long trip for AOL, which was best known for its $99 billion loss in 2002 and has continued to be considered a drag on the parent company until recently.

In November, Time Warner CEO Richard Parsons acknowledged that his company is in discussions with a number of companies on selling a stake in AOL but cautioned that the situation was fluid and might not necessarily result in a transaction.

Rather early on in the discussion phase, Yahoo! Inc. passed on buying all or part of AOL, leaving Microsoft Corp. and Google Inc. as potential bidders. As speculation abounds about whether AOL will hook up with one of those two firms or with a dark-horse bidder, deal activity among smaller Internet companies hit a torrid pace in the second half of this year.

"Anybody that runs a site that has a lot of traffic, especially among younger people, is licking their chops at the prospect of acquirers coming out of the woodwork," said Charles Warner, a media commentator and former AOL executive.

While Parsons seems to be on the sell side, other media titans are buying. News Corp., led by Rupert Murdoch, has spent more than $1 billion since July buying Internet companies.

Driving these deals is the convergence of power among the giants of the Internet. The primary companies have established themselves as the horizontal masters of the space. These include Amazon.com Inc. in merchandising, eBay Inc., with online auctions and payment services, and search engines Yahoo! and Google. Add diversified Microsoft and access giant AOL and you have the beneficiaries of the "first mover" advantage in cyberspace.

"It's too late to be a horizontal search player," says Ken Marlin, a Principal at Marlin & Associates., a New York-based investment bank that specializes in media and the Internet. He says the new mantra for dealmakers at Internet companies is "go vertical or go home."

But with that said, there still is room for maneuvering among the horizontal search giants and smaller companies that can partner with them. Marlin also notes that there are numerous opportunities for vertical players, in content and other areas, to innovate and create businesses that can profit from alliances with horizontal Internet players

Web 2.0 is a term often applied to the transition of the Web from a collection of websites to a full-fledged computing platform that serves Web applications to end users. Ultimately, Web 2.0 services are expected to replace desktop computing applications for many purposes. Among the factors that make the Web 2.0 Era exciting yet fraught with danger for companies trying to anticipate the direction of the industry is that nobody is sure what will work.

Mark Stahlman, a Managing Director at Caris & Co. in New York says that although content is generally understood as the way to drive service revenue on the Net, executives shouldn't take that as a given.

He cautions that the world is moving out of the domain of the mass media, where most executives have lived their lives, into a personal media world in which content takes on a different meaning.

As Internet players, large and small, jostle for position, a strategic certainty is that the impressive ramp-up of Google and the company's stratospheric stock market valuation - which has led some experts to dubbing the entire sector as the "Google Economy" - are forcing all other large players to react.

But before delving into what past deals can tell us about who will end up buying AOL or attractive smaller Internet properties, such as wedding media and services provider The Knot Inc. and women's online community iVillage Inc., it behooves dealmakers to look at the factors that have lifted AOL and placed it on the acquisition radar screens of several Internet giants.

A new strategic underpinning - the increase in Internet advertising - is driving the renaissance of Net properties. Internet advertising has grown from a tiny sub-sector of its industry to a robust segment. Over the next five years, experts predict that online advertising will grow four or five times as fast as other segments.

"Internet advertising has passed outdoor advertising in size, and it's by far the fastest growing form of advertising," Marlin says. In fact, he estimates that global online advertising revenue will increase by 40% in 2005, jumping from $9.6 billion in 2004 to $13 billion this year.

In fact, AOL is changing from a business model that relies on charging for Internet access - a declining business because users are switching to broadband access - to an advertising-driven portal with a large amount of free content.

Another industry dynamic that has made AOL attractive to potential bidders is the link between search and advertising. This is a key reason why AOL looks good to a pure search engine like Google and to Microsoft, whose search engine trails Google in popularity.

Any successful suitor for all or part of AOL would seek to increase its clout in what is known as paid search, which allows advertisers to bid for prominent display positions when computer users search for items relevant to its brands.

Both Microsoft and Google are committed to pursing the holy grail of paid search. Google is seen as more likely to take steps in that direction on its own while Microsoft would need a partner. Yahoo! also is testing various strategies to boost this part of its business.

Marlin says that while valuations for all of AOL have been floated in the $20 billion range, he believes that the unit could be worth as much as $50 million in four years.

New respect for the potential of online advertising is coming at a time when a partial or total sale of AOL would address other problems at Time Warner. Activist shareholder Carl Icahn has been pressuring Time Warner to take measures to boost its share price, which has been languishing at about $18 per share for two years. It also carries a significant debt load that an AOL deal could reduce.

In early November, Time Warner announced an increased stock buyback plan, hiking the volume of shares to be bought from $5 billion to $12.5 billion. It also reiterated plans to spin off 16% of its cable company, although Icahn is calling for a total sale of the unit.

Howard Anderson, a professor at the MIT's Sloan School of Management, thinks that Time Warner's most desired deal would be one in which it would be able to divest some of its AOL assets while still maintaining control of the business.

Many experts contacted by Mergers & Acquisitions believe that Microsoft will likely emerge as the successful suitor for all or part of AOL.

"Microsoft is the acquirer of choice for Time Warner for a number of reasons," Charles Warner says. For starters, Warner believes that the $283 billion market-cap company would be willing to pay the most. It could also exploit a number of synergies.

A Microsoft/AOL hookup also could cost Google its designation as AOL's preferred search engine and provider of associated advertising services. For the first six months of this year, 11% of Google's revenue came from advertising it placed on AOL sites.

Another advantage of a Microsoft/AOL deal would be the ability to link Microsoft's MSN instant messaging customers with AOL's instant messaging customer base. AOL instant messaging has 54 million users, and it recently announced a deal with Yahoo! to incorporate that company's 21 million instant messaging users. If it could throw in Microsoft's 23 million users, a Microsoft/AOL venture would have more than 95 million users. The increased bulk could drive a significant increase in revenues, such as through advertising that would reach a larger customer base.

Warner thinks that Time Warner would maintain control over AOL by selling a minority stake, possibility as much as 40%, so that it could profit from increased revenues that a Microsoft/AOL alliance would presumably spur but would still be able to control the unit's strategic direction.

Warner says that observers should consider Microsoft CEO Bill Gates' famously competitive nature as another factor that could drive a Microsoft/AOL deal. "It's driving him crazy that everyone's talking about Google, not Microsoft. This deal would give him a chance to reverse that."

Even commentators who are less certain that Microsoft would be the buyer do see an upside in such a deal as a blocking action against Google. Rob Helm, Director of Research at Directions on Microsoft, the only independent organization in the world devoted exclusively to tracking Microsoft, notes that while an acquisition of AOL would be a different kind of purchase than Microsoft has made in the past, it would have the benefit of possibly preventing Google from expanding in some areas such as software delivery over the Web.

A prelude to an alliance, Helm says, is that AOL has largely stopped disparaging Microsoft's products. He adds that although a Microsoft/AOL deal wouldn't be a direct threat to Google, it might cut off some of Google's air supply.

Strategically, an AOL link would help the software giant adjust to the shift of the computer industry's center of power from the desktop to the Web. In a nod to this reality, Microsoft launched on November 1 its Microsoft Live, which includes online versions of its Windows and Office software packages.

Helms points out that despite the fact that previous Microsoft deals have tended to be smaller and to be takeovers, as opposed to a joint venture that Time Warner may insist on, an AOL deal would be consistent with one theme in the company's growth scheme: Microsoft has often allied itself with former enemies, including International Business Machines Corp. to Apple Computer Corp.

Despite the benefits commentators see in a Microsoft/AOL deal, some pros say that Google will be the chosen partner, noting the company's secondary offering in September, which raised nearly $4.2 billion - the largest secondary offering by a U.S. high-tech company in 10 years. Google didn't say what the funds would be used for, but an acquisition war chest is a possibility.

Another popular scenario unites Google and Comcast in a bid for AOL. Press reports indicate that AOL would prefer to make a deal with Google first then bring Comcast into the arrangement later, in order to simply negotiations.

If Comcast were to make a joint bid with Google, it would be able to distribute AOL's content and build advertising revenue from its high-speed data customers. It might also be able to corral AOL's defecting dial-up customers to its cable broadband systems.

But Frank Dzubeck, President of Communication Network Architects, an industry analysis firm in Washington, D.C., questions the strategy of selling a part of AOL to one of Time Warner's biggest competitors. Comcast is the nation's largest cable company and Time Warner is No. 2.

"You see very few sales that sell something of value to a competitor," he says. "Most of Google's acquisitions have been in some way connected to its search business, but an AOL deal wouldn't add anything to its search capabilities, so I don't see them making that move."

When asked to speculate on dark-horse bidders, Dzubeck says he could see benefits for a major phone company like SBC Communications Inc. in creating an alliance with AOL. "The phone companies are searching for content to deliver to sweeten their relationship with consumers, so they might consider it," he says.

Marlin says he could imagine a deal that imitates the megamerger of Lycos Inc. and Spanish Internet service and content provider Terra Networks. AOL would be the distribution unit, although it also has content. A content-rich European company like Bertelsmann AG might make a proposal to use AOL's "pipes."

While there is also a possibility that News Corp. might work out a pact with AOL, Anderson thinks that scenario is unlikely because News Corp. prefers to have full operating control of its properties, and Time Warner might not be willing to give up control. "If he (Murdoch) can't have control, he won't do it, and I'm assuming that TW will want to remain control," Anderson says.

Warner also thinks that a News Corp. bid is unlikely. "Murdoch is smart enough to see what works and emulate it. It's OK to be second or third as long as you do it right."

Regardless of who the successful suitor for AOL is, many observers foresee an IPO of the combined entity a few years after the deal is completed.

While the giant search engine companies and potential competitors like Microsoft and AOL scratch to come with workable synergies, other Web-based companies are riding a merger wave.

News Corp., which came to the Internet party late, is making up for lost time and, in the process, is helping fix bankers' spotlight on the sector by absorbing mid-market companies. Increasing Internet presence is a priority at his company, Murdoch has said.

In the Internet space so far this year, News Corp. picked up Intermix Media Inc., owner of social networking site Myspace.com, in a $580 million deal; IGN Entertainment Inc., a leading community-based Internet media and services company for video games and other forms of digital entertainment, for approximately $650 million; United Kingdom-based classified advertising website Propertyfinder.com for about $25 million; and Seattle-based Scout Media Inc., which operates a network of sports websites and publishes local sports magazines.

Other mainstream media companies are buying up Internet properties: New York Times Co. bought search site About.com from Primedia Inc. for $410 million and Dow Jones & Co. bought news site Marketwatch.com for $519 million.

A signature deal of the Internet renaissance was Time Warner's $435 million Advertising.com buy in 2003. The deal signaled the acquirer's recovery from the early harsh effects of the AOL acquisition and the start of the new importance of adverting on the Web.

Other mid-market deals in the Internet space this year included Marchex Inc.'s acquisition of IndustryBrains in July and Dialog Group's purchase of AdValiant.com. On the private equity front, Hellman & Freeman bought DoubleClick Inc. last April.

Marlin says he expects to see a number of aggregations of dot.com sites in the next few years, noting that the growth strategy resembles the game plan that has driven magazine publishers to combine a number of titles under one roof in order to profit from management synergies.

Another dynamic that is driving Internet deals is the maturing of private equity portfolio companies. Marlin says that many of the acquisitions in the wave of pre-Bubble private equity deals have 10-year game plans. As a result, he says, many Internet portfolio companies will be put on the market toward the end of this decade as the funds that own them face deadlines to return investments to backers.

While experts say it's hard to figure out the shape the Web will take over time, they are willing to identify some likely opportunities for investors and dealmakers.

Marlin sees opportunities for companies that will complement the larger search engine providers, pointing to services that will provide contextual advertisements based on what a consumer is searching for.

Stahlman sees room for more companies in health care and financial services. He adds that in this huge Internet opportunity, winning will hinge on which company can best focus on the computer science aspects of the New Economy, more than which offline media property can best make the transition to the Web.

But whether it's computer science or content that turns out to the primary driver, the Web 2.0 Era is here and it will generate both expected and unexpected combinations.